Introduction
Financial ratios are widely used by business owners, lenders, and investors to evaluate performance and financial health. However, ratios can be misleading if accounting policies are not understood properly. Two businesses operating in the same industry with similar turnover and costs may show very different financial ratios solely due to differences in accounting policies.
This blog explains how accounting policy choices—such as depreciation methods, inventory valuation, and revenue recognition—impact financial ratios and why blind ratio comparison can lead to wrong decisions, especially for SMEs.
Why Accounting Policies Matter in Ratio Analysis
Accounting policies determine how income, expenses, assets, and liabilities are measured and reported. Financial ratios are calculated based on these reported numbers.
If accounting policies differ:
- Ratios lose comparability
- Financial performance may appear better or worse than reality
- Creditworthiness and profitability may be misjudged
Understanding the policy impact is essential for meaningful ratio interpretation.
Impact of Depreciation Methods on Financial Ratios
Common Depreciation Methods
- Straight Line Method (SLM)
- Written Down Value (WDV)
Effect on Ratios
- Profitability Ratios
- Higher depreciation → lower profits → lower net profit margin
- Return Ratios (ROCE / ROA)
- Higher depreciation reduces asset values faster, affecting returns
- Solvency Ratios
- Asset base changes impact debt-equity and leverage ratios
Key Insight
A business using WDV may appear less profitable in early years, even though cash flows are identical.
Impact of Inventory Valuation on Ratio Interpretation
Common Inventory Valuation Methods
- FIFO (First In, First Out)
- Weighted Average Cost
Effect on Ratios
- Gross Profit Margin
- FIFO (during rising prices) → higher profits
- Weighted Average → smoother margins
- Current Ratio
- Higher inventory valuation increases current assets
- Inventory Turnover Ratio
- Valuation method changes cost of goods sold
Key Insight
Two retailers with identical sales and stock movement may show different margins and liquidity ratios due to valuation method alone.
Impact of Revenue Recognition Policies
Revenue Recognition Differences
- Recognising revenue on invoicing
- Recognising revenue on completion or delivery
- Percentage of completion vs completed contract method
Effect on Ratios
- Profitability Ratios
- Early recognition inflates profits
Receivables Turnover
- Aggressive recognition increases receivables
- Liquidity Ratios
- Higher receivables improve current ratio but not cash position
Key Insight
Higher revenue does not always mean better performance—it may reflect timing differences.
Case Study: Two Similar SMEs with Different Accounting Policies
Background
- Both SMEs operate in the same manufacturing sector
- Annual turnover: ₹10 crore
- Similar cost structure and operations
Accounting Policy Differences
| Policy Area | SME A | SME B |
|---|---|---|
| Depreciation | Straight Line | WDV |
| Inventory Valuation | FIFO | Weighted Average |
| Revenue Recognition | On dispatch | On billing |
Resulting Ratio Comparison
| Ratio | SME A | SME B |
|---|---|---|
| Net Profit Margin | 9% | 6% |
| Current Ratio | 1.9 | 1.4 |
| ROCE | 18% | 13% |
| Inventory Turnover | Lower | Higher |
Analysis
- SME A appears more profitable and liquid
- SME B appears conservative and less efficient
- In reality, cash flows and operational efficiency are similar
The difference arises only due to accounting policy choices, not business performance.
Risks of Ignoring Accounting Policy Differences
- Incorrect peer comparison
- Wrong lending or investment decisions
- Overvaluation or undervaluation of business
- Misguided management actions
- Increased scrutiny during audits or assessments
Ratios without policy context can be dangerously misleading.
Best Practices for Meaningful Ratio Comparison
To ensure accurate analysis:
- Compare ratios only after reviewing accounting policies
- Adjust ratios for major policy differences where possible
- Focus on trends over time, not one-year figures
- Combine ratio analysis with cash flow review
- Use industry-specific and policy-adjusted benchmarks
Professional analysis adds clarity and prevents misinterpretation.
Conclusion
Financial ratios are powerful tools, but they are not absolute indicators of performance. Differences in depreciation methods, inventory valuation, and revenue recognition can significantly distort ratio comparisons between otherwise similar businesses.
For SMEs, lenders, and decision-makers, understanding the impact of accounting policies on ratios is critical to making informed, realistic, and fair judgments. Ratio analysis without accounting context is incomplete—and often misleading.
Need Professional Financial Analysis for Your Business?
Interpreting ratios correctly requires more than calculations—it requires accounting insight and industry understanding.
Verotus Finlegal Solutions LLP provides:
- Financial ratio analysis with policy adjustments
- SME benchmarking and performance diagnostics
- Loan and investor-ready financial reviews
- Strategic accounting and compliance advisory
📞 Contact Verotus Finlegal Solutions LLP to ensure your financial ratios reflect the true health of your business—not just accounting choices.
